Chapter 1.4: WHAT ARE DIFFERENT TYPES OF STOCKS?
Types of stocks
Stocks can be classified into multiple categories on various parameters – size of the company, dividend payment, industry, risk, volatility, as well as fundamentals.
- Stocks on the basis of ownership rules:
This is the most basic parameter for classifying stocks. In this case, the issuing company decides whether it will issue common, preferred or hybrid stocks.
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Preferred & common stocks:
The key difference between common and preferred stocks is in the promised dividend payments. Preferred stocks promise investors that a fixed amount will be paid as dividends every year. A common stock does not come with this promise. For this reason, the price of a preferred stock is not as volatile as that of a common stock. Another key difference between a common stock and a preferred stock is that the latter enjoy greater priority when the company is distributing surplus money.However, if the company is getting liquidated – its assets are being sold off to pay off investors, then the claims of preferred shareholders rank below that of the company’s creditors, and bond- or debenture-holders. Another distinction is that preferred shareholders may not have voting rights unlike holders of common stocks.
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Hybrid stocks:
Some companies also issue hybrid stocks. These are often preferred shares that come with an option to be converted into a fixed number of common stocks at a specified time. These kinds of stocks are called ‘convertible preferred shares’. Since these are hybrid stocks, they may or may not have voting rights like common stocks. -
Stocks with embedded-derivative options:
Some stocks come with an embedded derivative option. This means it could be ‘callable’ or ‘putable’. A ‘callable’ stock is one which has the option to be bought back by the company at a certain price or time. A ‘putable’ share gives the stockholder the option to sell it to the company at a prescribed time or price. These kinds of stocks are not commonly available.
- Stocks on the basis of market capitalization:
Stocks are also classified on the basis of the market value of the total shareholding of a company. This is calculated using market capitalization, where you multiply the share price by the total number of issued shares. There are three kinds of stocks on the basis of market capitalization:
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Small-cap stocks:
- ‘Cap’ is the short form of ‘Capitalization’. As the name suggests, these are stocks with the smallest values in the market. They often represent small-size companies. Generally companies that have a market capitalization in the range of up to Rs. 250 crore are small cap stocks.- These stocks are the best option for an investor who wishes to generate significant gains in the long run; as long he does not require current dividends and can withstand price volatility. This is because small companies have the potential to grow rapidly in the future. So, an investor may profit by buying the stock when it is cheaply available in the company’s initial stage. However, many of these companies are relatively new. So, it is difficult to predict how they will perform in the market.
- Being small enterprises, growth spurts dramatically affect their values and revenues, sending prices soaring. On the other hand, the stocks of these companies tend to be volatile and may decline dramatically.
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Mid-cap stocks:
- Mid-cap stocks are typically stocks of medium-sized companies. Generally, companies that have a market capitalization in the range of Rs. 250 crore and Rs. 4,000 crore are mid-cap stocks.- These are stocks of well-known companies, recognized as seasoned players in the market. They offer you the twin advantages of acquiring stocks with good growth potential as well as the stability of a larger company.
- Mid-cap stocks also include baby blue chips – companies that show steady growth backed by a good track record. They are like blue-chip stocks (which are large-cap stocks), but lack their size. These stocks tend to grow well over the long term.
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Large-cap stocks:
- Stocks of the largest companies in the market such as Tata, Reliance, ICICI are classified as large-cap stocks. They are often blue-chip firms.- Being established enterprises, they have at their disposal large reserves of cash to exploit new business opportunities. However, the sheer size of large-cap stocks does not let them grow as rapidly as smaller capitalized companies and the smaller stocks tend to outperform them over time.
- Investors, however, gain the advantages of reaping relatively higher dividends compared to small- and mid-cap stocks, while also ensuring the long-term preservation of their capital.
Stocks on the basis of dividend payments:
Dividends are the primary source of income until the shares are sold for a profit. Stocks can be classified on the basis of how much dividend the company pays.
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Income stocks:
- These are stocks that distribute a higher dividend in relation to their share price. They are also called dividend-yield or dog stocks. So, a higher dividend means larger income. This is why these stocks are also called income stocks.- Income stocks usually represent stable companies that distribute consistent dividends. However, these companies often are not high-growth companies. As a result, the stock’s price may not rise much. Preferred stocks are also income stocks, since they promise regular dividend payments.
- Income stocks are thus preferred by investors who are looking for a secondary source of income. They are relatively low-risk stocks.
- Investors are not taxed for their dividend income. This is another reason that long-term, relatively low-risk investors prefer income stocks.
- So how to find such stocks? Use the dividend-yield measure to identify stocks that pay high dividends. The dividend yield gives a measure of how much an investor is earning (per share) from the investment by way of total dividends. It is calculated by dividing the dividend announced by the share price, and then written in percentage format. For example, a stock with a price of Rs. 1000 offers a dividend of Rs. 5 per share has a dividend yield is 0.5%.
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Growth stocks:
- Not all stocks pay high dividends. This is because, companies prefer to reinvest their earnings for company operations. This usually helps the company grow at a faster rate. As a result, such stocks are often called growth stocks.- Since the company grows at a faster rate, the value of the shares also rises. This helps the investor earn a higher return when the stock is sold, although this comes at the expense of lower income through dividends.
- For this reason, investors choose such stocks for their long-term growth potential, and not for a secondary source of income.
- However, if the company ceases to grow, it cannot be called a growth stock. This makes such stocks more risky than income stocks.
Stocks on the basis of fundamentals:
Followers of value investing believe that a share price should equal the intrinsic value of the company’s share. They, thus, compare recent share prices with per-share earnings, profits and other financials to arrive at the intrinsic value per share.
- If a share price exceeds this intrinsic value, the stock is believed to be overvalued. In contrast, if the price is lower than the intrinsic value, the stock is considered to be undervalued.
- Undervalued stocks are also called ‘value stocks’. They are preferred by value investors, as they believe the share price will eventually rise in the future.
Stocks on the basis of risk:
Some stocks are riskier than others. This is because their share prices fluctuate more. However, just because a stock is risky does not mean investors should avoid it. Risky stocks have the potential to make you greater profits. Low-risk stocks, in contrast, give you lower returns.
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Blue-chip stocks:
These are stocks of well-established companies with stable earnings. These companies have lower liabilities like debt. This helps the companies pay regular dividends.Blue-chip stocks are thus considered safe and stabile. They are named after blue-colored chips in the game of poker, as the chips are considered the most valuable.
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Beta stocks:
Analysts measure risk – called beta – by calculating the volatility in its price. Beta values can have positive or negative values. The sign merely denotes if the stock is likely to move in sync with the market or against the market.What really matters is the absolute value of beta. Higher the beta, greater the volatility and thus more the risk. A beta value over 1 means the stock is more volatile than the market. Thus, high beta stocks are riskier. However, a smart investor can use this to make greater profits.
Stocks on the basis of price trends:
Prices of stocks often move in tandem with company earnings. Stocks are thus classified into two groups:
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Cyclical stocks:
Some companies are more affected by economic trends. Their growth moderates in a slow economy, or fastens in a booming economy. As a result, prices of such stocks tend to fluctuate more as economic conditions change.They rise during economic booms, and fall as the economy slows down. Stocks of automobile companies are the best example of cyclical stocks.
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Defensive stocks:
Unlike cyclical stocks, defensive stocks are issued by companies relatively unmoved by economic conditions. Best examples are stocks of companies in the food, beverages, drugs and insurance sectors.Such stocks are typically preferred when economic conditions are poor, while cyclical stocks are preferred when the economy is booming.
HOW TO BUY STOCKS?
Stocks can be classified into multiple categories on various parameters – size of the company, dividend payment, industry, risk, volatility, as well as fundamentals.
Step 1
Open demat and trading accounts. Without these two accounts, you cannot trade in the stock markets. Read how to open a demat account here, and a trading account here.
Step 2
First, analysis stocks and select ones that fit your investment profile. Read how to conduct stock market analysis.
Step 3
Once you have selected your stock, monitor it for a while. This is to ensure you buy at the lowest price possible in the near-term. Understand how the stock price moves.
First, analysis stocks and select ones that fit your investment profile. Read how to conduct stock market analysis.
Step 4
Decide when you want to place your order – during market times or after markets. This depends on the share price you are targeting. If you want to buy a stock at a fixed price, and the stock closed at that price, place the order after markets. If you feel you are likely to get a lower price during market hours, place it when the market is open for trading.
Step 5
Decide the kind of order you want to place. There are three kinds of orders – a limit order, a market order and a stop loss order, IOC (Immediate or cancel). A market order is the simplest of the lot – you simply place an order without any other specifications. In a limit order, you set an upper price limit. Suppose you have placed a limit order for 10 shares with a limit price of Rs. 100 when the share price is Rs. 99. You trade will be processed as long as shares are available at Rs. 100 or below. So, if only 8 shares are available, only 8 out of the 10 requested will be purchased. This ensures you don’t pay more than a specified amount.
Step 6
Once you have decided the specifics of your order, you either go online to your trading account to place the order, or call your broker. Give your bank account details so that the purchase money can be deducted from your account.
Step 7
Once you have decided the specifics of your order, you either go online to your trading account to place the order, or call your broker. Give your bank account details so that the purchase money can be deducted from your account.
What next?
Now, we have understood the basics of a stock market like the different kinds of stocks and how the share market works. So let us move on to understanding what are stock quotes. click here.
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